Credit Suisse Says the Fed Will Force a Mispricing of Risk

“Credit Suisse has made an important point with respect to the Fed’s purchases of MBS. As we know, a mortgage borrower is long an option to prepay. That means a mortgage lender is short this same prepayment option. Therefore a buyer of MBS is an options seller and the Fed is in effect selling vol into the market.

CS: – It is important, in our view, that the Fed continue to sell volatility – explicitly or implicitly – into the markets. This is at the heart of its quest to reduce term premiums and hence term interest rates. Buying mortgages results in a direct sale of volatility (prepayment risk) to the public. Extending the rate guidance to “mid 2015” represents an implicit sale of volatility – the Fed is giving up the option to hike (arguments about the Fed’s ability to renege notwithstanding). ”

Full article